Energy Economics 101

Published September 15, 2008

Yes, energy prices are still high. During the July 4, 2008 weekend, gasoline at the pump averaged nationwide more than $4 a gallon, and crude oil was over $145 per (55-gallon) barrel. Since then prices have eased–gasoline at the pump in late August averaged about $3.75 per gallon and crude oil on the Nymex was on the order of $115 per barrel for the front month.

It is also an election year. That means it is the silly season for government energy policy. Politicians from both parties decry the high prices and blame energy producers, speculators, OPEC, the Fed, the European Central Bank, oil refining companies, electric utilities, natural gas utilities, gasoline dealers, China, India, the Russians in Georgia, and soccer moms who drive SUVs. They are all price gougers or their enablers, according to the politicians.

Is it really all politics? One way to find the answer is to look back to 1998, when the crude oil price was $10 a barrel and the price of unleaded gasoline at the pump was just a couple of pennies over $1 a gallon. At the time there were no Congressional hearings and no TV investigations into how consumers were price-gouging the energy companies. That sounds like politics to me.

Markets Adjust

It also sounds like energy prices are very volatile. Indeed, they are. If one checks the implied volatility (equivalent to one standard deviation) from the trading of oil and natural gas puts and calls, they range from plus or minus 30 to 40 percent on an annualized basis during more normal times. Currently, expected oil volatility ranges from 40 to 50 percent annualized. By contrast, the implied volatility from the trading of the S&P 500 (VIX) index is currently less than 20 percent in the midst of a financial crisis (see

The volatilities quoted above are from the front month or the next month. They are higher for the near months than for the months farther out in time. The reason is that in the very short term there is little that can be done to alter the consumption or production of energy. Thus the only thing that can give immediately in the wake of a shock is the price. Over time, demand and supply adjustments can be made which will moderate both the expected price and volatility.

This is what appears to be happening in the current energy shock. First it should be noted that there have been a series of shocks creating a substantial upward trend in price. The pattern of crude oil futures prices suggests a continuation of the trend until the price peaks at the end of the first quarter of 2009. The implication is that more upward inertia is expected in the markets, and it is not until April or so of next year that the value of the supply and demand adjustments overtake the inertia.

There is evidence that consumers have been reducing their energy purchases, according to the Energy Information Administration. Gasoline consumption during the July 4th weekend was 3.3 percent lower than the year before. That’s a five-year low. Diesel demand, by contrast is up 6 percent from last year. Thus the national average diesel price has increased 65 percent since last year, while the gasoline price has increased only 38 percent.

No Additional Alternatives

One implication from this pattern is that nothing much beyond the usual market adjustments will lower oil prices. No quick fixes are possible. Not even a reduction in motor fuel excises and sales taxes will help–although it is almost always a good idea to allow taxpayers to retain more of the money they earn.

There is one exception to the blanket rule of no quick fixes, however. That is to halt the filling of the Strategic Petroleum Reserve. This occurred in May 2008. Before the halt, the SPR was soaking up 70,000 barrels per day. The Reserve now holds about 700 million barrels, more than enough for any foreseeable emergency.

One such emergency in the past was hurricane Katrina, which hit the Gulf Coast on August 29, 2005. In total, 20.8 million barrels of crude oil was released from the SPR, mostly in September 2005. That was appropriate because the storms shut in almost all of the 25 percent of the domestic crude oil that comes from the Gulf Coast. In other words, there was unexpected excess capacity at refineries, even though four refineries were shut down by the hurricane. Operating rates at refineries went from 97.5 percent in June 2005 to 94.2 percent in July, 93.6 percent in August, 83.6 percent in September, and 81.3 percent in October, according to the Energy Information Administration.

Another adjustment was made after Katrina and Rita hit the Gulf Coast: the regulations requiring reformulated gasoline were relaxed. This permitted imports of unreformulated gasoline from overseas. Imports went from about 1 million barrels a day in early August 2005 to 1.5 million barrels a day in early October 2005.

A comparison with current circumstances indicates that somewhat similar options now exist. Average operating rates for refineries were on the order of 90 percent as of June, and gasoline imports were approximately 1.2 million barrels a day in June. This implies some increases in refining output and gasoline imports are possible if reformulated gasoline regulations are relaxed as they were after Katrina and Rita.

Refinery Investments Needed

The process of long-term relief is more varied and more complicated. First, more drilling will help, even though it will take up to a decade to bring new discoveries into full production. The tide of public opinion seems to be turning in favor of drilling. The Wall Street Journal reported on July 12 and August 22, 2008 that even activists in Santa Barbara favor additional drilling if it is done under strict environmental regulation.

Athabasca tar sands in Canada represent an attractive alternative. This source can augment supplies without waiting a decade. There is one important obstacle however, which is political in nature. Investment must be made in refineries in the Midwest to handle the heavier crude oil that comes from the Canadian tar sands. Environmental approvals have been obtained for the upgrades at Whiting, Indiana, and Wood River, Illinois, but lately Sen. Dick Durbin (D-IL) and three members of Congress from Illinois, Melissa L. Bean, Rahm Emanuel, and Janice D. Schakowsky, have raised additional objections.

Their principal concern is that carbon dioxide emissions from “flaring” at the refineries would exceed new source emission standards that are under development. It is important to understand “flaring” at a refinery is unlike what occurs at remote producing properties where the flared natural gas is far from a market and thus uneconomic to capture and transport. At a refinery, where chemicals are routinely processed, there exists a danger from a random eruption of toxic gases. If not released, an explosion can occur. Circling the top of the stack where the emissions are released is a ring of jets that burn natural gas. The burners incinerate any toxic gases that are occasionally released.

Penalizing safety and health from a new energy source available in the near term in order to deal with an unproved warming threat a century or more in the future is not a good tradeoff.

Alternatives Still Not Feasible

Much has been made of the potential of solar and wind energy. Solar energy has the distinction of being the oldest of the new energy sources. It has sucked up more investment dollars and government subsidies than any other alternative energy source. Wind energy has received much attention recently from T. Boone Pickens. While he is obviously angling for increased government support of his wind power investments, he has at least made some honest admissions about the drawbacks. First, windmill farms of necessity must be located far from concentrations of consumers. More serious is Pickens’ admission that electricity generation by wind is very unreliable. It must be augmented by “peaking plants” powered by natural gas.

This, of course, would divert a premium fuel from more valuable uses elsewhere. It also makes the balancing of the grid more difficult, as the transmission and distribution system must be balanced every ten minutes or so. To the usual variation in the distribution of consumption, wind would bring serious balancing problems to the supply side. This, in turn, would make the whole grid more vulnerable to a cascading failure.

Pickens makes another suggestion that has considerable substance. He urges the adoption of compressed natural gas as a motor fuel for urban commercial fleet vehicles now powered by diesel fuel. According to NGVAMERICA, natural gas vehicles are currently displacing the equivalent of 200 million gallons of petroleum per year and could displace 10 billion gallons by the year 2017. Admittedly, this can occur only with substantial government support. However, the magnitude of the support would be substantially less than the subsidy for biofuels.

Something should be said about shale and biofuels. First, the good news. New technology has improved the in situ retorting (distilling) of the rock into a synthetic oil. There is also some potential for recovering natural gas from shale deposits. However, the old drawbacks remain. The Btu content is low, and recovery suffers from problems of land use, waste disposal, water use and wastewater management, greenhouse gas emissions, and air pollution. Biofuels have received huge amounts of government subsidy, and the current subsidy for ethanol has been party responsible for the increase of grain prices worldwide. In addition, as the cost of feedstock rises, so also does the price of livestock. This has been especially painful for the world’s poor, in countries such as Mexico. But what the heck, no sacrifice is too great if it puts money into the pockets of U.S. farmers.

There is an irony in this. The price of ethanol has fallen while the cost of corn has reached an all-time high. This has substantially reduced the profitability of ethanol plants. One wonders whether the ethanol investors hedged their price risk exposure.

Energy Independence Snake Oil

A word should be said about the calls for energy independence. The 2007 report of the National Petroleum Council predicted that energy demand will grow 50 to 60 percent by the year 2030. Coal, oil, and natural gas will all remain indispensable through 2030. Thus, the “concept of ‘energy independence’ is not realistic in the foreseeable future,” the report says. The standard model of supply arrays the sources of supply in ascending order of cost. The fact that imports are a part of the oil supply curve indicates that they are less costly than the alternative fuels listed above. The implication is that “energy independence” means more costly supplies will be substituted for less costly ones. That is a distortion in the allocation of resources that will raise prices, not lower them.

Of course, this does not mean no one will benefit from restricting imports. Clearly domestic producers benefit, as do the suppliers of subsidized energy. However, losses to the economy generally exceed the gains of the favored few. Hence I offer one word of advice: When you hear someone advocate energy independence, understand that he or she is selling snake oil.

Speculation Fears Unfounded

That observation brings us back to the issue of speculation and the hedging issue. Economist Craig Pirong observed in a July 11, 2008 essay in The Wall Street Journal that politicians of all stripes have been criticizing speculation. He cites Sen. Joseph Lieberman (I-CT) and Rep. Bart Stupak (D-MI) as claiming that financial institutions and investment funds have added $70 to the price of each barrel of oil. Lieberman and Stupak have thus proposed legislation to ban large financial institutions from the futures markets. Both presumptive presidential candidates have similarly promised retaliation against speculators if elected. Byron Dorgan (D-ND) has introduced a bill to “shut down casino-like betting.” Demanding investigations and rules are Sen. Mary Cantwell (D-WA) and House Speaker Nancy Pelosi (D-CA). Even financier George Soros and Fox News talk show host Bill O’Reilly have jumped on the bandwagon.

Can all these folks be wrong? In a word, yes.

Before reaching any conclusions about speculation and hedging, it seems only fair actually to describe the markets involved.

The first observation is that for every contract, there are two physical holdings corresponding to the long and short positions in the contract. With natural gas, for example, there are producers and consumers. The producers worry that prices will go down, and industrial consumers, for example, worry about prices going up. Individually, each faces a distribution of possible future prices. More specifically, it is a log-normal distribution. When a producer has a physical position with, say, natural gas to sell, and an industrial consumer has physical uses for the gas, both benefit by locking in a future price. This effectively collapses the expected price distribution and releases both parties from the need to build in more flexibility in the production and consumption processes.

The big players in any market are principals with opposing physical positions. However, there are also “locals” who trade for their own accounts instead of acting as agents for others. These parties arbitrage relationships among related markets and provide liquidity. They rarely hold open interest overnight. They liquidate. Their activities are sometimes described as snatching up nickels in the path of two moving steam rollers.

For the most part, few speculators hold large long or short positions. Some people think that hedge funds are speculators because they neither produce nor consume energy, but in fact they typically do have a physical position to protect. Their portfolios of stocks and bonds are affected by changes in energy prices.

However, there are instances when traders believe that they know the markets so well they can occasionally take an “educated” gamble. Long Term Capital Management is an example, from 1998. It extended beyond its arbitrage expertise and began a massive unwinding of positions that threatened a cascading default at markets throughout the world. The U.S. Federal Reserve bailed out LTCM and created in the process expectations that speculators in future collapses would be rescued. All this happened despite the fact that LTCM’s advisors included two Nobel laureates in economics: Myron Scholes and Robert Merton.

A more recent example is the SemGroup oil pipeline company, which is now in a Chapter 11 bankruptcy filing. Pipelines routinely lock in the price of the throughput during the time the commodity is in the pipe. Apparently, SemGroup CEO Tom Kavisto (a former Koch Industries VP of crude oil marketing) went far beyond this simple hedge. SemGroup maintained a large open short position that far exceeded the physical quantity of oil in the pipe. It was a bet that the oil price would fall sharply from record highs. According to Paul A MacAvoy, professor emeritus of the Yale School of Management, this is speculation, not hedging.

The interesting implication of these examples of premier hedging institutions is that when they go over the edge and speculate, they lose and lose big. The lesson is that speculation is not a winning strategy, even for masters of the financial universe.

There are also problems with government attempts to help out firms under attack.

Government Bailout, the Last Ditch

Hedging means taking a position in the market that is opposite the physical position. One example is for an airline such as Southwest to hedge its expected purchases of jet fuel by using the very liquid distillate contracts. As a result, Southwest has remained in the black while their competitors have posted huge losses. On the other side of that hedge is a counterparty with a large physical position to protect. Such a counterparty might be a refiner who’s worried that the current high prices might not last and therefore wants to lock in the future prices. The interesting implication from this example of offsetting trades is that refiners and other energy suppliers may not be pocketing all of the recent increases in energy prices.

Firms with large physical positions to protect have an obligation to their shareholders and employees to take out price insurance. If they do not hedge, they are gambling, pure and simple. What is particularly disturbing is that some of these nonhedgers compound their mistake by petitioning the government for a bailout. The big three auto companies are notable examples. Not only did they gamble on the cost of the energy factor of production, they put out a risky menu of product offerings heavily invested in gas-guzzling trucks and SUVs. Early in August the big three automakers met and agreed to ask the federal government for $40 billion in loans to ride out their current troubles, according to a Wall Street Journal editorial of August 22, 2008.

Apparently, plan B for nonhedgers is a government bailout. The fact that the government appears willing to use taxpayer money to bail out these firms creates a moral hazard that encourages more gambling with energy costs.

Damaging Government “Help”

There are other problems with government attempts to help out firms under attack. An example comes from the subprime market crisis. The Securities and Exchange Commission (SEC) identified 19 banks whose shares were vulnerable to short sellers. The SEC issued an emergency order prohibiting short selling the shares of the 19 banks from July 21 to August 13, 2008. Professor of Finance Arturo Bris of the IMD in Switzerland compared the effect on share prices for the 19 banks with a control group of other banks and found that short selling did not adversely affect the share price of the 19 banks. “Worse, the order has resulted in a decline in market quality for the EO-covered securities compared to comparable financial stocks. As a consequence, the EO restraints on short selling contributed to a decline in share prices for the 19 stocks” (see

If the government is successful with its efforts to intervene in the energy markets, their functions will be impaired. These functions include price discovery, hedging, and contract compliance. All of these are benefits to society. Government interventions are not.

If you liked the subprime mortgage disaster, you are going to love the destruction of the energy markets.

Jim Johnston ([email protected]) is an economist retired from the Amoco Corporation and a policy advisor to The Heartland Institute. The opinions expressed are his own and not necessarily those of The Heartland Institute.